For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

For many people, including me, falling interest rates have been the general trend in the bond market throughout our working lives. At the beginning of 1983, the year I graduated from business school, the yield of the benchmark 10-year U.S. Treasury note stood at more than 10%. It was less than 2.5% at the beginning of 2017.

Because bond prices move in the opposite direction from rates, my career happens to have overlapped with the greatest bull market for bonds in history.

It appears that may be changing. And, of course, there’s no shortage of advice about how to prepare for the shift.

Rates may be headed higher (really)

This bond bull market has reminded us time and again just how hard it is to predict when rates will rise or fall and by how much. If you follow bonds, you might recall the markets bracing for a sustained rate increase back in 2010 as the economy pulled out of recession, or again in 2013 when the Federal Reserve said it would start tapering its bond purchases, or again at the end of 2015 when the Fed raised short-term rates for the first time in almost a decade. And yet, prognostications notwithstanding, interest rates remained anchored near historical lows.

That said, rates seem to be on an upswing. With economic activity picking up, wages starting to move higher, and inflation coming off recent lows, the Fed has nudged short-term rates higher twice in recent months and has signaled that further gradual increases are likely through 2018. The perceived pro-growth stance of the new U.S. administration also has played a role in framing a case for higher rates.

Short-term pain, longer-term gain

Bond investors are understandably concerned. If interest rates shoot up, the market value of bonds will drop sharply, with prices falling to bring yields in line with the new, prevailing higher rates. That’s the potential short-term pain. But long-term investors should actually want rates to go up. If you like bonds that pay 2%, you should love bonds that pay 4%, right?

There’s a simple—though imperfect—rule of thumb that helps make this point clear. If the time frame of your investing goal exceeds the time frame of your bond portfolio (a medium-term goal matched with short-term bonds, or a long-term goal paired with bonds not quite as long-term), rising rates will work out in your favor, maybe decidedly so.

Think of it this way: If you have a big cash need in the near future—say, a tuition bill coming due in a few years—and you own bonds that are long-term in nature, this time frame mismatch could spell trouble if rates rise sharply; you’d be selling bonds that would be worth less. But if you’re saving to retire 10 or 15 years down the road and rates are steadily rising, over time you’ll be earning higher and higher yields. Josh Barrickman, our head of fixed income indexing for the Americas, calls it “the virtuous cycle of compounding interest at a higher rate.”

The bottom line is, you can end up better off than if rates hadn’t risen because you’re earning more income, which over time more than washes away any price hit.

Beware of short-sighted, short-term moves

This logic can be difficult to grasp, tempting anxious bond investors to make drastic shifts to lessen the immediate pain of rising rates. Unfortunately, such moves can backfire.

Taking shelter in short-term bonds, for example, might seem like a good idea. Their prices generally hold up better than those of longer-term bonds in a rising-rate environment. But they also offer less income.

For example, when the market started worrying about rising rates in 2010, moving into short-term securities—and staying there—would have been costly. Through 2016, those securities returned roughly half of what the broad U.S. bond market did.

Favoring high-yield bonds is another tack some investors take, expecting higher income to help cushion price declines. High-yield securities, however, typically perform best when stocks are rising, making them unlikely to zig when stocks zag.

We saw clear evidence of the correlation between stocks and high-yield bonds in the frantic markets following the United Kingdom’s vote to leave the European Union last year. From June 23 to June 27, both U.S. stocks and U.S. high-yield bonds lost ground. The broad U.S. bond market, meanwhile, climbed 1.2% as investors sought a safe haven.

Your portfolio is more than the sum of its parts

Different assets have different roles to play in a balanced and diversified portfolio. Stocks are valuable because they can produce higher returns over time, while bonds can provide a crucial counterweight to the volatility of stocks.

Perhaps the most important thing to keep in mind about bonds is that although their prices can fluctuate, they remain “fixed income” securities. Barring default, you can be certain of getting income until the bonds mature. It’s that income that drives returns for patient bond investors who resist the urge to jump in and out of the market.

A lot has changed since I first started following the bond market, but the important role that bonds can play in a balanced and diversified portfolio hasn’t.

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

Bill McNabb

Bill McNabb is chairman and chief executive officer of Vanguard. Bill joined Vanguard in 1986, became chief executive officer in 2008, and then chairman of the board of directors and the board of trustees in 2009. Previously, he led each of Vanguard’s client-facing business divisions, most recently serving as managing director of Vanguard’s institutional and international businesses. Bill is active in the investment management industry, and serves on the executive committee of the Investment Company Institute’s Board of Governors. He also serves on the boards of the Zoological Society of Philadelphia and the United Way of Greater Philadelphia and Southern New Jersey. Bill earned an A.B. at Dartmouth College and an M.B.A. at The Wharton School of the University of Pennsylvania.

Comments

Kate W. | September 17, 2017 8:47 pm

Donald G. | July 5, 2017 9:30 pm

Well Folkes I am really saddened by the negative way some of our bloggers are looking at this bond problem.There are Billions of people in this world that cannot even get in the door at vanguard and buy anything.Those poor old multi-billionaires who have not earned one thin dime of “earned income” and cannot even avail themselves of a 401k/nor an IRA for eleventy-leventy generations.They have to settle for full time staff of tax and financial analysts to do nothing but make them more billions each year.I am personally glad that I have trusted Vanguard with what some would say a measly amount with Vanguard. They want me to buy the whole market,including BONDS because they know how to tell an investor to diversify across the market to keep their portfolios from cratering during one of the great downturns that come around when you least expect it.I am going to continue to buy low and sell high just like Mr. Bogle advises his readers in at least one of the four books that I have read.It does not matter to me what the FED does because it is not going to force me to run around like a chicken with my head chopped of and crying out “woe is me” what am I going to do? The answer is NOTHING. I predict that the sun will come up on the morrow and I will keep on making money and reaching my goals that I have chosen with Vanguard.Remember the phrase “long term folkes” Thank you Mr. McNabb for taking some of your valuable time to write a very informative and thought provoking article.

Bruce I. | June 2, 2017 9:10 am

Buffett says he would never own bonds and asked the question why would anyone? When I retired and moved my 401k, brokerage, ira’s to Vanguard I put my trust in the advisor. I let her completely set up the portfolio. 65/35. Even though I repeated my concern about the future of bonds and interest rates she insisted the statistics over long periods of time would benefit me. When a person reaches retirement the fear of losing one’s wealth to the downs that occur in the market is sometimes not worth the gains at this stage of life. However hindsight after the market climbed makes us all experts. I don’t like bonds, never did. I agree with Buffet. However the non gambler that I am I keep the bonds that the advisor set up. Truth is, nobody knows. If I did, I’d be sailing the globe on my yacht.

Tom C. | May 23, 2017 12:52 pm

I understand the role bonds play in a portfolio, what I struggle with is why should I have foreign bonds at all. Vanguard’s Foreign Bond index fund has 33% of the fund invested in Japan and France. I don’t know how much diversification you really get with so much of the fund tied to just two countries. With such low rates, I don’t see a decent return for the risk that you are taking.

Valeri T. | May 22, 2017 6:27 pm

I can’t find information about investing in muni funds based on future tax policy change (Trump proposed individual tax reduction).
I am 72 and want to invest more money in tax-exempt funds . My tax bracket is >28%. But I don’t want to invest in time of uncertainty. Is there any good information about the subject on Vanguard Blog ?
Thanks,
Valeri.

Hi Valeri, thank you for your question. Uncertainty around future tax policy has been on clients’ minds recently for a variety of reasons. However, it can be very difficult to anticipate potential changes to tax policy. At this point, it may be too early to make any determination. It sounds like you’re on the right track regarding municipal bond funds. They generally benefit clients in higher tax brackets. You’ll want to make sure that you match the maturities of the bonds with your overall investing objectives. Best wishes.

Josh C. | May 20, 2017 6:49 am

>>>
If you follow bonds, you might recall the markets bracing for a sustained rate increase back in 2010 as the economy pulled out of recession, or again in 2013 when the Federal Reserve said it would start tapering its bond purchases, or again at the end of 2015
>>>

Why didn’t interest rates go up?
Because there was NO ‘economic recovery’ in those years.

Why did interest rates start going down in 1983?
Because we were coming off Jimmy Carters ‘Stagflation’ – it took sky high interest rates and President Ronald Reagan to get U.S. out of that mess.
Josh.

Nancy C. | June 15, 2017 12:34 pm

John D. | July 13, 2017 8:38 pm

Nancy,

Not everyone agrees with your assessment. Certainly Paul Volcker tried to reduce inflation as soon as he was appointed in mid-1979. But inflation remained high through 1981. As some see it, it was only after some of Reagan’s economic steps were implemented – the elimination of oil price controls and the reduction of marginal tax rates – that inflation went down.

As I see it, both Volcker and Reagan deserve credit.

Carter? Well, he did continue the deregulation process which Ford started. But he also kept price controls on domestic petroleum for most of his term, which dampened domestic supply and left us at the mercy of OPEC controlled prices.

Rodrigo C. | June 19, 2017 7:58 pm

R V. | May 11, 2017 6:32 pm

Your post is very qualitative like short term or long term. One important metric is to provide historical benchmarks that tells how long it takes for a bond fund to recover its losses when the interest rate rises by a given percent. If no research exists to provide such quantitative estimates, it is better to inform the public.

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.